Ch. 2: The Economic Problem.

• Topics

• Production Possibilities Frontier & Oppurt. Cost

• Efficient Allocation of resources

• Trade-off between current and future production.

• Gains from specialization and trade

• Importance of property rights and markets

Production Possibilities and Opportunity Cost

Production Possibilities Frontier (PPF) – boundary between combinations of goods and

services that can be produced and those that cannot.To illustrate PPF,

– Assume economy produces only two goods at a time and hold the quantities of all other goods and services constant.

– Assume everything else remains the same (ceteris paribus) except the two goods we’re considering.

PPF and Efficiency

Combinations of goods can be classified as

•Attainable

•Productively efficient

•Productively inefficient

•Unattainable

Coconuts

Fish

PPF and Opportunity Cost

• Measuring opportunity cost using the PPF.

• Opportunity cost of 1 million pizzas at– C– D

• |Slope of PPF| = opportunity cost of pizza

Production Possibilities and Opportunity Cost

Opportunity cost of 1 million CDs At C At D

|Inverse of PPF slope| = opportunity cost of CDs

Law of IMOC

• The Law of Increasing Marginal Opportunity Cost As the quantity

produced of each good increases, so does its opportunity cost.

Causes concave (bowed away from origin) PPF

What is the marginal opportunity cost of the 4th car?

25% 25%25%25%

30

TVs per day

Cars per day

0 1 2 3 4 5

20

17

15

10

a) 10 TVs

b) 5 TVs

c) 3 TVs

d) 1 TV

0%

A combination of 3 cars and 12 TVS would be

33% 33%33%

30

TVs per day

Cars per day

0 1 2 3 4 5

20

17

15

10

0%a) efficient

b) inefficient

c) unattainable

The opportunity cost of an additional TV is higher at

50%50%

30

TVs per day

Cars per day

0 1 2 3 4 5

20

17

15

10

0%A

B

a) A

b) B

Using Resources Efficiently

• This figure illustrates the marginal cost of pizza.

• As pizza production increases, the opportunity cost and the marginal cost of pizza increases.

• The Law of IMOC implies concavity of PPF

Using Resources Efficiently

A graph of marginal opportunity cost is upward sloping because of Law of IMOC.

Using Resources Efficiently

• Marginal Benefit (MB) of a good or service– Reflects a person’s “preferences”– Measures the benefit received from consuming one more unit of

it.– Can be measured by the amount that a person is willing to pay

for an additional unit of a good or service.

• Law of Decreasing MB (Law of Diminishing Marginal Utility) – the more we have of any good or service, the smaller is its

MB and the less we are willing to pay for an additional unit of it.

– MB Curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

Using Resources Efficiently

• The Marginal Benefit curve slopes downward to reflect Law of Decreasing Marginal

Benefit .

Using Resources Efficiently

• Two kinds of efficiency– Productive efficiency:

• When we cannot produce more of any one good without giving up some other good

• producing at a point on the PPF.

– Allocative efficiency• When we cannot produce more of any one good

without giving up some other good that we value more highly

• producing at the point on the PPF that we prefer above all other points.

• MB of last unit = MC of last unit

Allocative Efficiency

MB

MC

# of pizzas (in millions)

MB, MC measured in CDs

2.5

If Q<500, why should production increase?

If Q>500, why should production decrease?

Allocative Efficiency

MB

MC

# of pizzas (in millions)

MB, MC measured in CDs

2.5

If MC increases, how would allocatively efficient level change?

If MB increases, how would allocatively efficient level change?

Using Resources Efficiently

• The point of allocative efficiency – point at which marginal

benefit equals marginal cost.

– determined by the quantity at which MB=MC

– Changes as preferences (MB) or costs (MC) change.

Suppose that for health reasons, people prefer more tomatoes in their diet. This will cause the allocatively efficient amount of tomato production to increase because ____.

a) MC decreases

b) MC increases

c) MB increases

d) MB decreases

Economic Growth

• Economic Growth– expansion of PPF– Increases the standard of living

• Determinants of economic growth: Technological change Capital accumulation

Physical or human

Economic Growth

Consumer goods

Capital Goods

•How will the choice between consumer and capital goods affect future economic growth?

• What kind of government policies can affect location on PPF?

Gains From Trade

• Comparative Advantage– A person has a comparative advantage in

production of a good if that person can produce the good at a lower opportunity cost than anyone else.

• Absolute advantage– A person has an absolute advantage in an

activity if that person can produce more of the good in a given amount of time than anyone else.

Gains From Trade

Coconuts per day

Fish per day

Mary

Bill

9

9

15

10

Who has absolute advantage in

coconutsfish

Who has comparative advantage in

coconutsfish

Gains From Trade

Coconuts per day

Fish per day

Mary

Bill

9

9

15

10

Suppose no trade and on PPF. •If Bill produces 3 fish, he can produce ____ coconuts.•If Mary produces 6 fish, she can produce ____ coconuts.•World production is ____ fish and ___ coconuts.

If specialize and tradeworld production could be ____ fish and ____ coconuts.

What are the gains from trade?

Gains From Trade

What is the “world” PPF for Mary & Bill?

Coconuts per day

Fish per day

Gains From Trade

• Nations can gain from specialization and trade

• Because the gains from trade arise from comparative (not absolute) advantage, people can gain from trade even if they have an absolute advantage in all commodities.

Gains from Trade Revisited

Suppose there is a small island economy with 20 Irish and 10 Germans. Each Irish can catch either 10 fish or gather 40 coconuts in a day. Each German can catch either 6 fish or 30 coconuts in a day.

The ___ have the comparative advantage in fish and the ___ have the comparative advantage in coconuts.

a) Irish; Irish

b) Germans; Germans

c) Irish; Germans

d) Germans; Irish

Draw PPF Here

If everyone split their time equally between fishing and coconuts, total production would be ______ fish and _____ coconuts.

130; 550

160; 680

200; 600

240; 800

25% 25%25%25%

300%

a) 130; 550

b) 160; 680

c) 200; 600

d) 240; 800

Based upon the PPF, if production is organized efficiently and 130 fish are produced, _____ coconuts can be produced.

360520

580640

25% 25%25%25%

300%

a) 360

b) 520

c) 580

d) 640

Based upon the PPF, if production is organized efficiently and 130 fish are produced along with the maximum possible number of coconuts, the fish would be produced by _____ and the coconuts would be produced by _____.

Only Iri

sh; O

nly Germ

ans

Irish

and Germ

ans; Only

I...

Only Iri

sh; Ir

ish and G

er...

Irish

and Germ

ans; Iris

h a..

25% 25%25%25%

300%

a) Only Irish; Only Germans

b) Irish and Germans; Only Irish

c) Only Irish; Irish and Germans

d) Irish and Germans; Irish and Germans.

The Market Economy

• Trade is organized using two key social institutions: Property rights Markets

• Property Rights– the social arrangements that govern ownership, use,

and disposal of resources, goods or services.

• Markets– any arrangement that enables buyers and sellers to

get information and do business with each other.